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| Source: Deutsche Bank Research |
The global economy is strong and this year is the fourth year of economic growth above 5% - the best sustained period of expansion since the 1950’s. Global growth has been fuelled by the spectacular expansion in the economic powerhouses of Asia-Pacific: China and India. The manufacturing companies of Germany, which accounts for 30% of the Eurozone economy, have been boosted by robust demand in emerging economies while overseas demand has prevented America from sliding into recession. Last month, Deutsche Bank Research highlighted the importance of the machine tools sector when it said that the typical German mechanical engineering company employs nearly 150 people and generates annual turnover of €26 m. In 2006, the sector’s roughly 6,000 businesses with a combined workforce of some 873,000 generated revenues of €167 bn.
The Wall Street Journal reported on August 9th that foreign operations contributed to strong second-quarter results in recent weeks from a number of US companies, ranging from giants like General Motors Corp. and Citigroup Inc. to smaller manufacturers like Harley-Davidson Inc. Part of this upswing can be traced to a weaker dollar, which creates an automatic gain when a company translates overseas profits back into now-devalued greenbacks. Last week, IT giant Hewlett-Packard reported that 65% of its revenues in its fiscal fourth quarter came from outside of the United States.
The Journal says that the trend toward US companies earning more profits overseas isn't new, but it has accelerated in recent years, and has spread to more types of companies, reflecting the growing globalization of US business, says Ed Yardeni, president of Yardeni Research Inc. The share of international profits at US companies has grown steadily since the 1960s, when they accounted for about 5%, and now accounts for about a quarter of all profits, he says, citing Commerce Department data.
International earnings of US companies grew 16.4% in the first quarter compared with a year ago, while domestic earnings rose just 2.7%, says Joseph Quinlan, chief market strategist at Banc of America Capital Management, using Commerce Department data.
The US has escaped recession thus far through strong overseas earnings but today, America may need a cut in its key interest rate to assist its housing sector and avoid a recession. The question for the Eurozone is whether the European Central Bank will reverse course on its signaled plan to raise its key interest rate to 4.25% on September 6th next?
In the early part of this decade, the dot-com bust and 9/11 prompted the Fed under Alan Greenspan to aggressively cut the federal funds rate to 1%. In the Eurozone, the European Central Bank (ECB) cut its key interest rate from a high of 4.7% to 2% in mid 2003. The historically low cost of money led to a global asset boom in particular in housing. In the corporate world, private equity investments in companies, financed by cheap corporate debt, became an important financing mechanism and in the US property sector, interest-only loans became an important segment of the home-loans market. Loans were aggressively targeted to people with poor credit records, and when the problems in the US high credit risk subprime home loans market, which first surfaced last February, become more serious than expected because the system of lenders being directly responsible for the risks that they assumed in lending money, was changed with risk was sold to onward to financial companies, including foreign banks through re-packaging by Wall Street firms.
There is currently a global credit problem because the extent of the exposure to the subprime crisis is not clear. Banks have become cautious about refinancing and assuming corporate debt risk, as there is fear of exposure to the subprime crisis. Last week, ECB President Jean-Claude Trichet welcomed what her termed a “repricing” of risk following the provision of liquidty to the Eurozone banking system. His interest is not to provide a lifeline to investors but to ensure that the real economy will not be damaged by the current volatility.
The recovery in markets following the cut by the US Federal Reserve in its discount rate, on Friday, was manna from heaven for at least a day. The reduction in the interest rate that the Fed charges banks for loans to 5.75% was not a cut in its key federal funds rate and the market is looking to the meeting of the rate-setting Federal Open Market Committee on September 18th to provide another antidote for frentic traders, through a cut in the rate from 5.25%. Investors and forecasters on Friday were penciling in a cut in rates of 0.75% by the year-end.
America’s housing market is in recession and the wish that there would be no contagion to the rest of the market has not been realized, while most forecasters coupled with Fed Chairman Ben Bernanke and US Treasury Secretary Hank Paulson, who was Chairman of US investment bank Goldman Sachs until the summer of 2006, were proved wrong about the fallout. Now that fears have been raised even about the financial stability of the largest US home loans lender Countrywide and the latest reading of US consumer sentiment has been negative, the Fed has to look at the implications of the market volatility and the credit crunch, for US consumer spending, which accounts for about 70% of the economy.
In Europe, the majority of financial services’ economists may well have got ahead of themselves last week in foreseeing an inevitable backtrack by the ECB on its signal that it would raise its key interest rate in September.
In the absence of an impending recession, the ECB is faced with a rise in core inflation and German trade unions seeking inflation busting pay rises. Too much may well have been read into a remark by Professor Axel Weber, President of the Bundesbank and member of the ECB’s Governing Council, who said in comments to reporters on Friday that that in addition to price stability it is also important for the ECB to do its part in ensuring financial stability.
“The German and European economies are essentially healthy," Weber said in an interview with a German radio station, that was broadcast on Saturday but was originally taped on Thursday.
Professor Weber said that the slowdown in German economic growth in the second quarter showed that the government's fiscal policy -- namely its increase in value-added tax -- was having a dampening effect on growth of Germany's gross domestic product.
"Despite the market turbulence I see no point to revise macroeconomic forecasts," he said.
"The German economy can weather this storm," Weber added.
While growth in the Eurozone slowed in the second quarter, it is still strong and last week, a Eurozone index of economic sentiment remained robust.
On Thursday, detailed figures provided by the EU’s statistical office Eurostat, showed that “core” inflation - which gives an indication of underlying trends and excludes volatile oil and unprocessed food prices - remained at 1.9% in July, even though the overall rate fell to 1.8%. Over the past year, “core” inflation has risen steadily from a low of 1.3 per cent at the start of 2006, and last month was above the headline rate for the first time in more than three years, the data showed.
The cost of oil has increased 41% since the middle of January and food prices are also on the rise because of drought and the increase in biofuel production. Deutsche Bank Research reported last week that German shoppers have been paying more for groceries lately, up to 50% more for butter within a few days. Spending 10 cents more for a litre of milk may be noticed by individual consumers and painful for some, but the effect on the overall economy is hardly a cause for concern. Even if yearly foodstuff inflation doubled this year, this would just add 0.15 percentage points to the overall inflation rate. Moreover, the current high world prices for many agricultural commodities are partly the result of short-term factors such as recent falls in output due to drought (e.g. for grains in Australia in 2006 and currently in Europe).
Deutsche Bank says that given the particularly fierce competition in the retail sector, German food prices are low compared to its European neighbours. But the big picture is that, relative to the past, food prices are expected to stay high or even move higher for structural reasons. A typical family in the developed world has been spending around 10% of their income on food, compared to 40%, 50 years ago. Mechanization and the Green Revolution caused a steady fall in the real price of food. At the same time, the increase in labour productivity allowed for rising wages, hence higher spending beyond the basics. Now, consumers world-wide have to get used to spending slightly more on food.
Finally, a rise in trade union militancy, which was recently highlighted with the threatened German rail strike, is also a factor for the ECB to worry about. Real incomes have stagnated over the past decade and it is resulting in frustration among workers as the economy powers ahead.
ECB President Jean-Claude Trichet always stresses that the Governing Council does not pre-commit on interest rate hikes. The expectation of a rise at the September 6th meeting will be realized unless there is a perceived serious threat to the real economy from the current credit crunch. Trichet and his colleagues will be very reluctant to be seen as bailing out exuberant investors.
It is still more likely than not that the ECB will raise its key rate to 4.25% at the next meeting of the Governing Council.
The Governing Council could also indicate that monetary policy has moved from accommodative to neutral, signalling to the market that the current tightening phase is over.
It in effect will have the opportunity to kill two birds with the same stone!
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